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Arun Hariharan

Lean

How to Calculate Financial Results From Lean Six Sigma Projects

What gets measured gets managed better

Published: Tuesday, August 20, 2013 - 17:00

During the past dozen years, companies I’ve been involved with have completed more than a thousand lean Six Sigma (LSS) projects. About 40 percent of these projects had a direct financial benefit, either in revenue or cost savings that immediately reflected on the company’s financial statements. However, the overall improvements to the business are much bigger than the immediate financial benefits.

We followed a method for calculating and reporting the financial results for the LSS projects. The method underwent several refinements and evolved into a robust standard. Our method is neither unique nor very different from what most companies use to track LSS initiatives, but I share it here as a useful best practice.

In a recent column, I wrote about three types of improvement projects: quality, revenue-enhancing, and cost-saving. Quality improvement projects typically attack a defect or customer complaint, and seek to eliminate, reduce, or ideally, prevent the defect. To keep financial reporting of LSS conservative, we limited our calculation and reporting to revenue-enhancing projects and cost-saving projects, which, unlike quality improvements, have a direct effect on a company’s annual financial statements.

Revenue-enhancing projects

These projects generally involve introducing simple process discipline and in-process measures for sales-related processes. For example, one company that sells through distributors realized that a large number of them hadn’t sold anything for several months. When this problem was taken up as an LSS project, 29 percent of the inactive distributors became active after they went through the LSS process.

The revenue actually earned through the now-activated distributors was considered the revenue from that LSS project. To be as accurate and conservative as possible, we eliminated any results that might have come in even if we hadn’t done the project. To find them, we compared a group of distributors that had been through the LSS process against a control group of distributors that had not yet been through the process. The percent of distributors from the group that did not go through the LSS process, but became active anyway, was 0.8 percent. Because these results were negligible compared to the results from the LSS project, we attributed the revenue earned through the reactivated distributors to the LSS project.

Where possible, you may do similar experiments to find out if some results would have happened anyway. If this is a significant amount, that can be deducted when reporting your LSS results.

Another kind of revenue-enhancing project is to increase first-time-right (FTR) sales. These are sales orders that are complete and accurate when brought in by salespeople and don’t need any rework. For example, one company noticed that only 20 percent of the sales orders brought in by its salespeople were FTR. For the other 80 percent, the company had to go back to the customer more than once to clarify information or complete some requirement. What was really worrisome was that nearly half of these customers had changed their mind when they were approached again, and were no longer interested in buying. Clearly, this was lost revenue.

The company took this issue up as an LSS project. As a result the percent of FTR orders to total sales orders went from 20 percent to more than 90 percent. A year later, the CEO acknowledged that revenue for the year was 35-percent higher than what it would have otherwise been, solely because of the increase in FTR sales. The impact on profit was even more spectacular. The company estimated that its profit for the year was about 50-percent higher than what it would have otherwise been, now that an overwhelming majority of sales orders were FTR.

The revenue for such projects is calculated as the incremental revenue that actually resulted from the higher FTR. In this example, before the LSS project, half of the 80 percent of non-FTR orders, that is 40 percent of all orders, was lost revenue. Through the LSS project, that defect rate was reduced from 80 percent to 10 percent. We assumed that, as before, half of the remaining non-FTR orders would not result in revenue. Because non-FTR orders were down to 10 percent, lost revenue was therefore now 5 percent of all orders (as compared to 40% before the LSS project).

This is what the CEO meant when he said that the revenue was 35-percent higher than what it would have been without the project. The project’s contribution to revenue has two elements. The first is the profit contributed by the 35-percent incremental revenue. The second is the profit from reducing the cost of rework (from 80 percent needing rework, to only 10 percent needing it). The combined effect of these two elements for this project was a 50-percent increase in profit.

Cost-saving projects

These projects typically are concerned with eliminating waste or improving productivity, often by streamlining a process. Financial results from such projects are fairly straightforward to calculate. If the per-unit cost (e.g., of a part, car, appliance, insurance policy or banking service) is reduced by, say, $10 per unit, the actual cost savings is the per-unit savings multiplied by the actual number of units produced during the year.

Three-stage financial calculation

For revenue-enhancing LSS projects, we calculate financial results at three stages. First, at the start of the project, we estimate the potential financial benefits (revenue or cost savings) for a 12-month period after completing the project. To take a simple example, at the start of a project aimed at reducing the cost of producing a certain product, it is estimated that the per-unit cost will be reduced by $10. The method for calculating this and any assumptions are agreed on by the project leader and the company’s CFO, and signed off by both of them on the project charter. It is further estimated that the number of units produced in 12 months after completing the project will be one million units. Thus, the estimated cost saving in one year after the project is projected to be $10 million.

Second, at the end of the project (most LSS projects took us between four and six months to complete), we find that the project succeeded in reducing the per-unit cost by $11. So the projected cost saving for the next 12 months, assuming that the estimate for the number of units that will be produced remains unchanged at one million, is revised from the $10 million to $11 million. If the estimate for the number of units is also revised, the projected cost saving is revised accordingly at this stage.

Third, we report the actual cost savings every month for a minimum of 12 months after the end of each project. In this example, the actual number of units produced each month multiplied by the per-unit saving of $11 dollars is the actual revenue from savings. To keep the example simple, I’m not including possible changes in the per-unit cost reduction in, say, six months down the line due to extraneous factors or special causes. If these occur, this change will also be considered when calculating the actual savings.

At each of the three stages, the project champion and the CFO jointly sign off the projected or actual financial results.

Other practices to keep financial reporting conservative

Needless to say, any cost of doing the project or implementing the improvement or process change is deducted from the financial benefits to report the net results.

We calculate the total financial results from LSS as the total of revenue or cost savings from individual projects calculated as above. For this, actual financial results from each individual project are taken for a period of 12 months from the end of each project. While the company continues to reap the benefits from most projects way beyond 12 months, for financial reporting of LSS results, we stop including results after the twelfth month. As a further precaution, we double-check to ensure that there is no duplication of results. There may be the odd case where two projects contribute to the same financial result but must be counted only once.

Do LSS projects reflect on the company’s financial statements?

CFOs sometimes ask whether LSS project results show on the company’s financial statements. If the methods described here are followed, the answer is a resounding yes.

To illustrate this, let’s take the same example from above, where an LSS project resulted in a net cost reduction of $11 per unit of product. If one million units were produced during the year following this project, the cost saving to the company (and hence the increase in profit) is $11 million. Will there be a separate line on this company’s financial statements showing this $11 million as “cost savings from LSS?” Of course not. Is the annual profit on the company’s financial statements higher by $11 million than what it would have been if this project had not been done? Absolutely yes.

Why it’s important to measure financial results from LSS

There are several reasons why it’s important to measure financial results. The most obvious, of course, is that what gets measured gets managed better and gives you better results. Second, we would never have fully realized how much a structured approach, process discipline, and in-process measurements contribute to revenue and profits. Third, and equally important, is the motivation that your project teams derive from seeing how their projects are contributing to business results. What better way to keep people motivated than through these very positive and visible results?

Finally, in a small number of projects, calculating financial benefits might not be so straightforward. In those cases it’s better that the project champion, who is the functional expert in that area, and the CFO work together right at the start of the project and clearly agree on the method that will be used to calculate financial results.

It can be quite unmotivating to your project teams to do all the hard work, actually deliver results, and then find themselves embroiled in unsavory battles to prove how their project has helped the company. Creating this motivating atmosphere is the responsibility of senior management.

Discuss

About The Author

Arun Hariharan’s picture

Arun Hariharan

Arun Hariharan, author of Continuous Permanent Improvement (ASQ 2014), and The Strategic Knowledge Management Handbook (ASQ 2015) is a strategic quality, knowledge management (KM), and performance management practitioner with nearly three decades of experience in these fields. He has worked with several large companies and helped them achieve substantial and sustained results through quality and customer focus. He is the founder and CEO of The CPi Coach, a company that provides partnership, consulting, and training in business excellence and related areas. Former roles held by Hariharan include president of quality and knowledge management at Reliance Capital Ltd, and senior vice-president of quality and knowledge management at Bharti Airtel Ltd, India. He is a frequent speaker at quality and KM events around the world. He is also the author of more than 50 published papers on quality and KM.

Comments

mess-assure

Yes Mr. Hariharan, you do hit the bull's eye: motivation is the key word, the key point. We keep lamenting competition of Far East Countries but we keep not investigating why their labor-force, apparently unmotivated, keeps being far ahead than ours, well fed and abundantly optionaled. May be we measure the wrong things, or measure things in the wrong way. In any case, if we were taught that at the beginning there was the Word, we are now brought to believe that first of all there is the Meter.